Why China Likely Won’t Buy Fewer U.S. Treasury Bonds

A January 2018 Bloomberg article suggests that Chinese officials may reduce their purchases of U.S. government bonds. It is very unlikely that China can do so in any meaningful way because doing so would almost certainly be costly for Beijing. And even if China took this step, it would have either no impact or a positive impact on the U.S. economy.

The furor over recent comments by Chinese officials that they may reduce their purchases of U.S. Treasury bonds show just how poorly the world understands the balance of payments. Here is what Bloomberg had to say:

Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.

China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly. China’s State Administration of Foreign Exchange didn’t immediately reply to a fax seeking comment on the matter.

Why would China reduce its purchases of U.S. government bonds? In a January 2018 Financial Times article, ING’s Asia chief economist and head of research, Rob Carnell, was quoted as saying that the Chinese decision may be in reaction to U.S. President Donald Trump’s trade rhetoric:

The most likely explanation, aside from a mistake, in this author’s opinion, is to demonstrate that China is unlikely to passively accept tariffs on steel, aluminum, and solar panels—industries the U.S. Trade authorities are looking to penalise shortly for unfair trade practices.

If China is indeed threatening to retaliate against any U.S. trade action by reducing its purchases of U.S. government bonds, not only would this be a pretty hollow threat, but in fact it would be exactly what Washington wants. To see why, let’s consider all the ways in which Beijing can reduce its purchases of U.S. government bonds.

Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.

Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.

Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.

Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.

Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.

These five paths cover every possible way Beijing can reduce official purchases of U.S. government bonds. As I will explain, the first two ways would change nothing for either China or the United States. The second two ways would change nothing for China but would cause the U.S. trade deficit to decline, either in ways that would reduce U.S. unemployment or that would reduce U.S. debt. Finally, the fifth way would cause the U.S. trade deficit to decline in ways that would likely either reduce U.S. unemployment or reduce U.S. debt; this fifth way would also cause the Chinese trade surplus to decline in ways that would likely either increase Chinese unemployment or increase Chinese debt.

By purchasing fewer U.S. government bonds, in other words, Beijing would leave the United States either unchanged or better off, while doing so would also leave China either unchanged or worse off. This doesn’t strike me as a policy Beijing is likely to pursue hotly, and Washington would certainly not be opposed to it. Let’s consider each possibility in turn.

1) Beijing could buy fewer U.S. government bonds and more of other U.S. assets, so that net capital flows from China to the United States would remain unchanged.

This would be a non-event. Basically, it means that Beijing would redirect its purchases from U.S. government bonds to other U.S. assets. Of course, the seller of those other assets would now be forced to deploy the proceeds of the sales elsewhere, so that directly or eventually the proceeds would be used to buy U.S. government bonds. The only thing that would change, in this case, is that Beijing would have swapped its ownership of U.S. assets from one form to another.

U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Because this outcome represents nothing more than a swap by Beijing out of lower-risk assets into higher-risk assets, with no net change in demand for U.S. assets, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.

U.S. investment: There would be no change in overall U.S. investment except to the extent that tightening credit spreads would cause a small rise in risky U.S. investments.

U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have an impact on the U.S. current account or trade deficits.

Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have an impact on the Chinese current account or trade surpluses.

2) Beijing could buy fewer U.S. government and other U.S. assets, but other Chinese entities could then in turn buy more U.S. assets, so that net capital flows from China to the United States would stay unchanged.

Again, this would largely be a non-event. The volume of Chinese capital flows to the United States would be unaffected, but there would be minor changes in the composition of assets to which the flows are directed.

U.S. interest rates: There would be no net impact on overall U.S. interest rates and a very small impact on relative interest rates. Again, the result might be at most a small rise in yields on riskless assets matched by an equivalent tightening of credit spreads.

U.S. investment: There would be no change in overall U.S. investment, except to the extent that tightening credit spreads cause a small rise in risky U.S. investments.

U.S. trade deficit: Beijing’s decision would leave the U.S. capital account surplus unchanged, so it could not have any impact on the U.S. current account or trade deficits.

Chinese trade surplus: Beijing’s decision would leave the Chinese capital account deficit unchanged, so it could not have any impact on the Chinese current account or trade surpluses.

3) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developed countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developed countries would increase by the same amount.

In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States, and an increase in its capital account deficits and current account surpluses with the rest of the developed world. The reduction in the U.S. current account deficit would mean a reduction in the excess of U.S. investment over U.S. savings. If U.S. investment were constrained by an inability to access savings, this reduction would occur in the form of lower U.S. investment. Because that is not the case, it would occur in the form of higher U.S. savings.

Savings can be forced up in many different ways, almost always involving either less debt or lower unemployment. For example, a reduction in capital inflows can deflate asset bubbles and so discourage consumption through wealth effects, or such a reduction can lower consumption by raising interest rates on consumer credit, or even by encouraging stronger consumer lending standards. A reduction in capital inflows can also increase savings by reducing unemployment. One way or another, in economies like the United States that do not suffer from weak access to capital, a reduction in foreign capital inflows automatically increases domestic savings.

It may be harder than we think for China to redirect capital flows from the United States to other developed economies. Continental Europe, Japan, and the UK are the only developed economies large enough to absorb a significant change in the volume of capital inflows, but none of them are eager to absorb the current account implications. Some economists, misunderstanding the nature of the account identity that ties net capital inflows to the gap between investment and savings, will undoubtedly argue that these inflows would cause investment in Europe, Japan, and the UK to rise, but this is wrong. That would only be true if investment in these economies had previously been constrained by scarce savings, but because this is clearly not the case in today’s environment, the impact of higher capital inflows into developed economies could only be to reduce domestic savings.

For developed economies, in other words, significantly higher capital inflows from abroad would either cause savings to decline as the inflows strengthen their currencies and reduce exports—causing either unemployment or consumption to rise—or, if their central banks act to sterilize the inflows, to increase imports by increasing consumer debt. If continental Europe, Japan, and the UK are unwilling to accept higher unemployment or higher debt, they would be unwilling to allow unlimited Chinese access to domestic investment and may quickly take steps to retaliate.

U.S. interest rates: Contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up. Because the reduction of the U.S. capital account surplus would result in an increase in U.S. savings, this would fully match the reduction in Chinese savings that had previously been imported by the United States.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.

4) Beijing and other Chinese entities could buy fewer U.S. assets and replace them with an equivalently larger amount of assets from other developing countries, so that net capital flows from China to the United States would be reduced, and net capital flows from China to other developing countries would increase by the same amount.

In this case, China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States and an increase in its capital account deficits and current account surpluses with the developing world. As explained above, the reduction in the U.S. current account deficit would occur through an increase in U.S. savings.

Because investment in developing countries is often constrained by difficulty accessing global savings, a redirection of Chinese capital from the United States to developing countries would boost investment in those countries. The problem is that China has had a very bad experience with its investments in developing countries and may not be eager to raise them significantly more than it has already planned.

U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would leave the Chinese capital account deficit unchanged, it would have no impact on the Chinese current account or trade surpluses.

5) Beijing and other Chinese entities could buy fewer U.S. assets and not replace them by purchasing an equivalently larger amount of assets from other countries, so that net capital flows from China to the United States and to the world would be reduced.

Finally, China could reduce its overall capital account deficit by reducing the amount of capital directed to the United States and not replacing it with capital directed elsewhere. This would mean that China must either reduce domestic savings or increase domestic investment. This would also mean, of course, that it must run lower current account and trade surpluses.

One way savings can decline quickly is if a drop in exports causes unemployment to rise. The only other way is if there is a surge in consumer debt. For investment to rise quickly, there almost certainly has to be either a rise in unsold inventory as exports drop or a rise in nonproductive investment into infrastructure. In either case, this would mean a rising debt burden.

U.S. interest rates: Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise except to the extent that it would cause U.S. economic growth to pick up.

U.S. investment: There would be no change in overall U.S. investment and an increase in U.S. savings, the latter driven either by lower unemployment or a reduction in consumer debt.

U.S. trade deficit: Because Beijing’s decision would reduce the overall U.S. capital account surplus, it would also reduce the U.S. current account and trade deficits.

Chinese trade surplus: Because Beijing’s decision would reduce the Chinese capital account deficit, it would necessarily also result in a reduction in the Chinese current account or trade surpluses.

Conclusion

Even if Beijing forced institutions like the People’s Bank of China to purchase fewer U.S. government bonds, such a step cannot credibly be seen as meaningful retaliation against rising trade protectionism in the United States. As I have tried to show, Beijing’s decision would either have no impact at all on the U.S. balance of payments, or it would have a positive impact. It would have almost no impact on U.S. interest rates, except to the extent perhaps of a slight narrowing of credit spreads to balance a slight increase in riskless rates.

It would also have no impact on the Chinese balance of payments in the case that it leaves the U.S. balance of payments unaffected. To the extent that it would result in a narrower U.S. deficit, there are only three possible ways this might affect the Chinese balance.

First, China could export more capital to developed countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of angering its trade partners and inviting retaliation. Second, China could export more capital to developing countries, in which case the decision would have no immediate impact on China’s overall balance of payments, but it would run the risk of increasing its investment losses abroad. And third, China could simply reduce its capital exports abroad, in which case it would be forced into a lower trade surplus, which could only be countered, in China’s case, with higher unemployment or a much faster increase in debt.

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Michael Pettis

January 17, 20187:40 pm

Yes, Maeglinde, but this is politically difficult to do, and almost impossible to do quickly enough. They have been trying to do so at least since then-Premier Wen's promise to make the rebalancing of income a top priority, in a March 2007 speech, but the imbalances are actually worse today than they were at the time. Over the long term they must effect these transfers, but they cannot do so quickly enough to balance a change in the balance of payments.

"Again, and contrary to popular perception, a reduction of Chinese capital flows to the United States would not cause U.S. interest rates to rise ... " So relieved the laws of supply and demand, which are very burdensome regulations, have been repealed. I guess China's demand for $ denominated bonds will be replaced by Bitcoins or a new cyber currency created with my free app which you can download from the Apple store.

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Yok

January 16, 20183:40 pm

Zizzer. Look at it this way. No matter how willing the chinese are to loan the yuan, in this country there is no market for them - US citizens can't buy a single thing in this country with them. The chinese can only finance their own trade surplus. That credit is a very small part of the overall economy, and in my judgement, meaningless. People in this country borrow in dollars. You know, I'm picking up a whiff of republicanism. Interest rates. The wonderful marketplace. You know 150 years ago when there was a downturn, interest rates shot up. Now days, like in the GFC, around the world interest rates went down - across all time spans. You are ignorant of the central bank. They determine interest rates.

If you really think that foreign capital inflows into developed economies cause lower interest rates, Zizzer, then you have an easily testable hypothesis, and one that should have been pretty obvious, whose results should have bothered you a bit more than they seem to. There should be, if you are right, an inverse correlation between domestic interest rates and the size of a country's current account deficit: the larger a country's current account deficit, the lower its domestic interest rates should be, and the larger the current surplus, the higher its domestic interest rates should be. You can test that across countries or you can test it in one country, like the US, at different times.
At the beginning of this essay, you’ll remember that I suggested “just how poorly the world understands the balance of payments”. Luckily for us it turns out that we don’t need to repeal the laws of supply and demand because, and this really was the main point of this essay, a reduction of capital inflows into economies in which investment is not constrained by low savings causes the supply of savings to rise.

Under case 5, where it says " ...This would mean that China must either recue domestic savings ..." it should read "...must either reduce..."
Under Conclusions, 6th line, where it says "...It would have almost no impact on U.S. interest rates, expect to the extent..." it should be "..., except to the extent..."

In that case there would be no net impact on the balance of payments, AiT, and there would be a small shift in the relevant credit spreads as Chinese entities effectively swapped out of US government bonds into US real estate.

In that case there would be no net impact on the balance of payments, AiT, and there would be a small shift in the relevant credit spreads as Chinese entities effectively swapped out of US government bonds into US real estate.

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AlwaysinTrouble

January 17, 20183:46 pm

Michael,
In case 3, you said, “..China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States..”
Doesn’t this contradict what you have said elsewhere (sorry if I do not have a specific citation at hand), that bilateral capital and current account balances do not have to match? China can run a current account surplus with Mexico, for example, and use the proceeds the buy Treasuries. Then Mexico can run surpluses with third countries as could the U.S. In the past, you cited an article “Systemic equilibrium in a Bretton Woods II-type international monetary system” by Austin in the Journal of Post Keynesian Economics that explained this in detail.

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Michael Pettis

January 18, 20186:08 pm

Yes, you are right, AiT. I meant to say "....but there would be a reduction in its bilateral current account surplus with the United States.” I don't know why I inserted the incorrect "capital account deficit", which of course remains unchanged.

I am sorry. I take that back, AiT. In fact I was right to say "China’s overall capital account deficit and current account surplus would remain unchanged, but there would be a reduction in its bilateral capital account deficit and current account surplus with the United States, and an increase in its capital account deficits and current account surpluses with the rest of the developed world. " You are right that bilateral accounts do not have to balance, but in this case both would decline even though they are not equal to each other. I should never post comments just after I get out of bed.

Michael, I think that you were right in the first response. In Cases 3 and 4 China replaces purchases of US treasuries with assets from a third country or countries. Even if China manages to maintain the RMB/$ rate, the currency of the new reserve provider will appreciate against the $. The US bilateral current account will improve against the third party, but the effect on the bilateral China-US current account is ambiguous - in theory (although as a practical matter, the bilateral China-US imbalance will probably shrink). But the big effect will be on the new reserve provider which will see its current account deficits tend to grow against both China and the US.

Michael, I think that you were right in the first response. In Cases 3 and 4 China replaces purchases of US treasuries with assets from a third country or countries. Even if China manages to maintain the RMB/$ rate, the currency of the new reserve provider will appreciate against the $. The US bilateral current account will improve against the third party, but the effect on the bilateral China-US current account is ambiguous - in theory (although as a practical matter, the bilateral China-US imbalance will probably shrink). But the big effect will be on the new reserve provider which will see its current account deficits tend to grow against both China and the US.

What would be the impact of Apple´s plan to repatriate 350bn USD in 5 years to the USA? Assuming most of its cash is held in foreign currencies : A boost in investments, strengthening the dollar, which in turn would aggravate the Trade imbalance ?

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Michael Pettis

January 19, 20189:31 pm

If all other things remain unchanged, Gregory, this would mean that the US capital account surplus would be higher over the five year period by $350 billion. In the unlikely case that this causes Apple to make a $350 billion investment it would not have otherwise made, US investment will rise by $350 billion. If not, US savings will decline by $350 billion. In either case the gap between investment and savings will rise by $350 billion, along with the US current account deficit.

Gregory,
Great question. Adam Looney of Brookings has a great answer. It's actually held in the U.S. already. Once a tax lawyer is involved, nothing is as it seems.
“U.S. multinational corporations can defer paying tax on profits they earn abroad indefinitely by agreeing not to use the earnings for certain purposes, like paying dividends to shareholders, financing domestic acquisitions, guaranteeing loans, or making investments in physical capital in the U.S. In short, the rules prohibit a company from using pre-tax money in transactions that benefit shareholders.. But those rules don’t place requirements on the geographic location of the cash. Multinational firms are allowed to bring those dollars back to the U.S. and to invest them in our financial system.”
As Apple, Inc. states in its annual report: “The Company’s cash and cash equivalents held by foreign subsidiaries are generally based in U.S. dollar-denominated holdings.” Microsoft’s annual report states that more than 90 percent of its $124 billion in deferred cash was invested in U.S government and agency securities, corporate debt, or mortgage backed securities. Those examples are typical. Of the 15 companies with the largest cash balances—companies that hold almost $1 trillion in cash—about 95 percent of the total cash was invested in the U.S.
Since I can't post a link, you can find Looney's article on the Brookings' website under: "Repatriated earnings won’t help American workers—but taxing those earnings can"
Don't know whether to laugh, cry, or spit.

Gregory,
Great question. Adam Looney of Brookings has a great answer. It's actually held in the U.S. already. Once a tax lawyer is involved, nothing is as it seems.
“U.S. multinational corporations can defer paying tax on profits they earn abroad indefinitely by agreeing not to use the earnings for certain purposes, like paying dividends to shareholders, financing domestic acquisitions, guaranteeing loans, or making investments in physical capital in the U.S. In short, the rules prohibit a company from using pre-tax money in transactions that benefit shareholders.. But those rules don’t place requirements on the geographic location of the cash. Multinational firms are allowed to bring those dollars back to the U.S. and to invest them in our financial system.”
As Apple, Inc. states in its annual report: “The Company’s cash and cash equivalents held by foreign subsidiaries are generally based in U.S. dollar-denominated holdings.” Microsoft’s annual report states that more than 90 percent of its $124 billion in deferred cash was invested in U.S government and agency securities, corporate debt, or mortgage backed securities. Those examples are typical. Of the 15 companies with the largest cash balances—companies that hold almost $1 trillion in cash—about 95 percent of the total cash was invested in the U.S.
Since I can't post a link, you can find Looney's article on the Brookings' website under: "Repatriated earnings won’t help American workers—but taxing those earnings can"
Don't know whether to laugh, cry, or spit.

Greg. Always In Trouble replies with a wonderful, appropriate post. Michael answered the post "assuming the cash is held in foreign currencies." The real truth is the money is already here. It's all about entrances in a ledger. In my opinion, IF they do assemble and build human and physical productive resources here, savings and investment will register equal rises. If they distribute it to shareholders, some of it will go to consumption and lower the level of savings.

Hello Professor,
I am hearing a lot about the potential for retaliatory trade actions by the U.S. as a result of its Section 301 investigation into Chinese trade practices, i.e., forced transfers of IP and know-how, refusal to allow U.S. companies to invest in and own Chinese assets, etc. The two remedies I hear most discussed are tariffs and restricting Chinese investment in the U.S., and maybe a combination of the two. My question to you is what is the likely result if the U.S. restricts Chinese investment in the U.S., something I read Bob Lighthizer favors? What form is that most likely to take and would the results approximate any of your scenarios above? I am thinking the result could be a reduction in the U.S. trade deficit and an increase in U.S. savings on the U.S. side, unless China ups its buys of U.S. treasuries as a response (assuming, of course, that the U.S. doesn’t restrict those purchases also), and on the Chinese side I guess it depends on whether they buy assets or treasuries from other countries to replace the lost U.S. investment or not. What do you think? I want to know how that would play out and the economic consequences for both countries. Thank you.

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Michael Pettis

January 22, 20181:49 am

I wrote about that in last week's issue of my newsletter, Sulla. Here is what I wrote:
"We shouldn’t assume that if the US makes Chinese investment in US companies more difficult, this will reduce Chinese capital flows to the US. As long China pegs its currency, it’s net capital account outflow is unlikely to change, because changes in reserves are simply a function of the net flows arising from the combination of the current account and the non-PBoC part of the capital account. The rise or fall of PBoC reserves, in other words, is simply the plug factor that allows the balance of payments to balance at any predetermined exchange rate.
In that case what isn’t invested abroad by Chinese companies will be invested abroad by the PBoC in the form of rising reserves. A reduction in capital outflows by Chinese entities will simply cause PBoC reserves to go up by an equivalent amount. Total Chinese investment in the US will be unchanged, but its form would differ as investment in risky instruments decline and investment in US government bonds rise by the same amount."

Thank you Professor. What if, however, the U.S. prevented purchases of its treasuries as well as limiting private Chinese investment into the U.S.? I doubt this will happen, but if that is the case, whether by simply not allowing it or counter-intervention in the currency markets to counteract the effect of such Chinese U.S. government bond purchases, that would seem to be a major development, something possibly heralding a change in having the U.S. dollar as the world's reserve currency and necessitating a global conference to address the situation lest we go back to the 1920s and 1930s when the Pound Sterling could no longer act as a global reserve currency on its own and the U.S. refused to permit the dollar to take over. For the U.S., it should be a good thing and resolve the Triffin Dilemma in favor of higher growth, productivity, savings and employment domestically, but it seems like it could be pretty chaotic for the world.

I wrote about that in last week's issue of my newsletter, Sulla. Here is what I wrote:
"We shouldn’t assume that if the US makes Chinese investment in US companies more difficult, this will reduce Chinese capital flows to the US. As long China pegs its currency, it’s net capital account outflow is unlikely to change, because changes in reserves are simply a function of the net flows arising from the combination of the current account and the non-PBoC part of the capital account. The rise or fall of PBoC reserves, in other words, is simply the plug factor that allows the balance of payments to balance at any predetermined exchange rate.
In that case what isn’t invested abroad by Chinese companies will be invested abroad by the PBoC in the form of rising reserves. A reduction in capital outflows by Chinese entities will simply cause PBoC reserves to go up by an equivalent amount. Total Chinese investment in the US will be unchanged, but its form would differ as investment in risky instruments decline and investment in US government bonds rise by the same amount."

i am struggling to understand the arguments around the effect of capital account on trade balance. it has none, two different sources of flows. capital account can finance trade (or rather current) account, but it doesnt increase nor decrease it.

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Yok

January 19, 201811:39 am

Elena. By definition the Capital Account equals the Current Account, the greater portion of which is trade in goods. This is an identity. Your thinking is off where you say "capital account CAN finance trade account." The capital account MUST AND WILL drive the current account. It goes both ways, one or the other can drive. If a chinese insists on buying something here, and is will to suffer whatever discount on real value, the yuan released can only go one place. Home. Through currency, trade, commercial markets that yuan will go home and purchase something.

Of course, it was once a requirement for countries to participate in the international trading and monetary system that the respective external accounts be balanced.
Actually, it is still a requirement today. This is very explicitly stipulated for instance in the preamble of the General Agreement on Tariffs and Trade (GATT, now WTO) and in Article 1 of the Articles on Agreement of the IMF, which are still in force today, even though not respected for decades.
The deluge of non-sense commentary on China possibly buying less US Treasury bonds is very telling. Not a single voice spoke to suggest that, instead of recycling its trade surplus in buying US debt, China could perhaps buy US goods and thus comply with its international obligations. Of course, international obligations are symmetrical and the US must also take simultaneous steps to reduce its external deficit, one of which could precisely be to restrict the ability of surplus countries to access its capital markets.

Even though the non-compliance with WTO and IMF agreements seems to be largely at the expense of the US, it is important to understand that the US is largely responsible for the situation.
First, by insisting at Bretton Woods in 1944 that the US Dollar be the international reserve currency. This, in the long term, made it inevitable that the US Dollar would be accumulated by trading partners, making a deficit of the current account inevitable. It would have been easier to keep cross external balances in equilibrium with a truly international unit of account, as proposed by Keynes at the Bretton Woods conference. This was the initial weakness of the Bretton Woods accord and the reason why it broke in 1971. Any substantial resolution of global trade imbalances requires the US to give up the international status of the US Dollar. This is still far away as the mistaken perception that this is an « exorbitant privilege » remains in public opinion. In previous article, Michael Pettis has shown that this is more an « exorbitant burden » but opinion has not shifted yet.
Second, the US was the main intellectual influence behind the theory of floating exchange rates post 1971. It was believed that the market would set exchange rates at levels consistent with cross external balances equilibrium. The experience has proved this theory incorrect. Instead, duplication of credit between deficit and surplus countries has kept the system far from equilibrium while sending global relative debt to record levels. The US still has to shift from this theory of floating exchange rate.
Lastly, the US has been the driving force behind trade globalization since the late 1970’s. In the non-system of floating exchange rates not balancing cross external accounts, this global trade liberalization has opened vast opportunities for cost arbitrage at the expense of workers in higher cost developed countries. Trump is now reacting to this aspect but it is likely that resolving trade imbalances will be impossible without addressing the international exchange rate regime and the particular status of the US Dollar.

DvD. I take non-compliance and being the driving force, as deriving from selfish motivations of a relatively small number of very wealthy and powerful people eager to make personal gain even at gain at the expense of the public trust. I take all the leveraged buyouts, Milken, the de-industrialization, as the cost arbitrage profit taking engineered by these people. Politically and resource access wise, the people with the most muscle always want the least restriction to the exercise of their power. The weak and vulnerable need the rules. I liked Mike's Triffin paper. The inequality and injustice around the world creates an environment that engenders fascism, authoritarianism, anger, a desire to control and dominate.

Yes, but please note that, while inequality increased substantially within countries, it simultaneously decreased between countries due to trade globalization in the context of exchange rates not balancing cross current accounts. The dramatic increase in under-employment and the stagnation of average living standards in developed countries has been accompanied by a dramatic increase in employment and average living standards in developing countries. True, this has been achieved at the cost of extraordinary and unsustainable increases in total relative debt everywhere, both in deficit and surplus countries (Japan, China, etc). This is where the big danger lies.
So, I would not necessarily talk about « inequality and injustice around the world » like you but more about inequality and injustice within countries, and in particular within developed countries. There, it is true that the arbitrage gains arising from free trade between economic zones of vastly different living standards without trade balance equilibrium and being captured by a small minority are correctly viewed as un-earned gains and giving rise to social tensions which could easily degenerate into political tensions. There lies another big danger.
The least we can say is that policymakers of all sides have been utterly inadequate to identify and address these problematic imbalances. At its core, this is a leadership crisis.

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KK

January 23, 201811:45 am

Michael, thank you for this informative post. One question - under outcome #3, when you write "...or, if their central banks act to sterilize the inflows, to increase imports by increasing consumer debt." How does a central bank sterilization operation increase consumer debt? Thanks

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jsn

January 25, 20181:10 pm

Is record high Chinese investment in Germany driving the near record German Trade surplus? If so, would this be a mechanism through which China could reduce its US Treasury holdings by transferring them to other countries as payment for Euros with which to invest?

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Steve

March 13, 20189:28 pm

I feel like part of this equation is missing. If China reduces its current account surplus / capital account deficit with the United States, my understanding is the dollar will fall. Accordingly, the purchasing power of U.S. consumers will fall. When you talk about interest rates above, do you mean real interest rates or nominal interest rates? It seems like with the U.S. economy running near full employment, this would result in inflationary pressure in the U.S. Effectively the U.S. now has to export another $350 billion of goods and services that otherwise would have been consumed domestically. Faced with higher prices relative to wages or less access to credit, people in the aggregate are forced to consume less, right? That's the part I'm still trying to understand. I don't think it is entirely a free lunch for the U.S. even though it might be a desirable outcome from a broader perspective.

jsn, Steve. jsn, by your question "Is record high Chinese investment in Germany driving the near record German Trade surplus?", you reveal a fundamental misunderstanding of Current and Capital Accounts. If China was investing heavily into Germany, the result for Germany(or the EU) would be a trade deficit to China. You have it exactly the opposite. If Chinese Currency was entering Germany to invest that very same currency has no place to go but home back to China to buy capital or consumer goods. How do you know that there is record high Chinese investment in Germany? I don't. Since your premise is wrong, your following question does not require responding. Steve, a part of the equation was missing. But to your first question I ask "why would the dollar fall in response to China lowering its trade surplus to the US? Generally speaking a currency will fall because of a trade deficit, not because it is being reduced. But it's academic. China and many countries around the world peg to the dollar to enjoy trade advantage - it's not a marketplace. All hypothetical. Where great wealth and power are at stake markets go out the window and are replaced with the competition of wealth and power against wealth and power between the elites for those things they consider of greater inportence to themselves

Yok, that's a good point. I think I get where we end up. U.S. net imports would fall. U.S. GDP does not necessarily increase or decrease, but there would be second order effects that I would find hard to predict. Higher domestic savings due to the reduction in the capital account surplus mean lower government expenditures, investment or consumption. It seems that consumption or G would bear the hit the per Prof. Pettis. Aggregate demand (ignoring second order effects and frictions) would theoretically remain constant due to the reduction in the current accounts deficit . I don't really understand the transmission mechanism here, whereby households eat the difference. Higher interest rates and hence higher taxes? A weaker dollar and hence higher prices? That's what I still don't get.

Steve you raise many questions. There are many variables, direct and indirect, and many times the line of action is hard to determine. Forgive me, but I thought you might have gotten some notions in your head from the media, that really, is irreconcilable with reality. For years I tried to make sense of the things I heard and read. I've come to dismiss it as propaganda from on high. If I saw it correctly, you, to me, mistakenly believe that US consumers will take a hit if China lowers its, purchasing of US bonds. It will not. It would help US workers and consumers. Unalloyed it would increase US GDP. The dollar may fall somewhat in reference tot he Yuan. However. When domestic production moves to replace imports that means domestic investment for facilities, construction work, jobs in production. The net, to me, would be a boon for US workers - you got it the opposite way. Domestic employment goes up, domestic investment goes up, domestic workers no longer compete so much on price with workers overseas, so wages are given a lift. Because domestic investment goes up, domestic savings goes up. Yes, it's possible some would suffer with the import substitution, their dollar wouldn't buy as much, a minority, but in the big picture it would be good for the US. The whole problem with the unbalanced trade is that some people take advantage of others. Don't believe all the talk in the media of how the steel and aluminum tariffs will be the end of us all. Nonsense. The wealthy and the powerful want everyone to believe that we all live in one big free marketplace, perfect in its' distribution of wealth and opportunities, and selfish, self centered acts will upset it all. They want freedom to act in their interests without hindrance, to take advantage of fellow citizens, their venality hidden and victims believing that if you're not doing well it's your own fault - the marketplace has tested you and found you wanting.

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Nikhil Gupta

April 16, 20188:46 pm

"...A reduction in capital inflows can also increase savings by reducing unemployment...". How does lower unemployment raise savings and not consumption? I understand that both could happen; however, don't think you imply the same.

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Yok

April 16, 201812:43 pm

Nikhil. As I understand Michael and your question. You already accept that unemployment will decrease, because less foreign goods are brought into the country. More employment here implies more investment in productive capacity here. In a closed economy, which the US approaches more closely by the reduction of foreign participation, savings = investment. To my way of thinking, the increased productive capacity is the increased savings. Of course consumption could stay the same or increase too. Paper savings would increase during that time before the productive capacity is brought into action.

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Nikhil Gupta

April 17, 20187:17 pm

Thank you for replying Yok. "...More employment here implies more investment in productive capacity here...". Is the lack of employable labor restricting investment growth? I don't think so. To my question, after some more thought, I think "lower unemployment will boost total disposable income, which is most likely to boost both consumption and savings". If so, however, this linkage between lower capital flows and higher savings is very different from the others mentioned by Michael, which implies higher savings through lower consumption.

Nikhil. The difference in who is doing the saving. When foreign savings come here, it harms rather than helps. We don't need the money or the goods. Foreign goods un-employ Americans. When, say, the govt proceeds to update or build needed facilities in this country, the govt invests, employing more people, real increased production, real savings. If the govt fears inflation they may raise taxes, lowering consumption, freeing up real resources - substituting investment for consumption as the purpose of production. In a country like ours, we have a great deal of real wealth, we don't need vendor financing - foreign money go home. I've been reading Mike for awhile. I haven't found conflicts in his thought.

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